Tuesday, September 21, 2010

FOMC Statement, 9/21/10

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The FOMC is registering concern that the measured inflation rate is below its target, typically thought to be in the neighborhood of 2%. Of course the FOMC is careful to state this in terms of its dual mandate, as laid out in the Full Employment and Balanced Growth Act, otherwise known as the Humphrey-Hawkins Act. The Fed is supposed to care not only about inflation, but about real aggregate economic activity, as specified (somewhat vaguely) in the Act. I have always viewed the Phillips-curve language in the FOMC statement (language like "...substantial resource slack continuing to restrain cost pressures...") as the Fed attempting to have its cake and eat it too. If we accept that the Phillips curve is a structural relationship (of course a highly dubious notion, ever since Friedman wrote about it in the 1960s), then there is no conflict implicit in the Humphrey-Hawkins dual mandate. When there is resource slack we will then expect low inflation, and therefore both the inflation hawks and the Keynesians can be happy with a more accommodating monetary policy. If we're doubtful about the Phillips curve, we are going to have a harder time getting these two groups to agree.

The FOMC is signaling that it is concerned about the low level of inflation. They either hope that this will induce expectations of higher future inflation that will actually produce higher inflation today, or they are thinking that their previously announced policy of holding constant the size of the Fed's balance sheet as mortgage-backed securities (MBS) run off will produce results, or both. One policy they might have pursued is to actually increase the size of the Fed's balance sheet, perhaps by purchasing more long-term Treasury securities, as Jim Bullard seems to be considering here.

The actual change in policy, announced in the FOMC's August 10 statement was:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.

Now, it is not entirely clear why this matters. This is essentially the same as what would happen if the Fed exchanged MBS for long-term Treasury securities. What's actually happening is that some people are prepaying their mortgages and refinancing, so that a mortgage that was effectively on the balance sheet of the Fed is now on some private balance sheet, and the Fed is holding a Treasury security instead. Why should this matter? MBS on the Fed's balance sheet are effectively loans to the private sector; Treasury securities are loans to the Federal government which are going to be paid off with future taxes, so these are also effectively the liabilities of the private sector. What's the difference? It could be that the Treasury debt is not in fact backed by future taxes; maybe the private sector perceives that Treasury debt will just be rolled over by the Federal government, and some of it will be monetized. Then, we might think of the Fed's policy action as telling us to expect more future inflation, as MBS and Treasury securities are "backed" differently. The MBS were financed by issuing outside money that will be retired in the future, but Treasury securities are purchased with outside money that will be outstanding indefinitely, and will therefore be inflationary.

Of course, all of this depends on public perceptions about how outside money (currency and reserves) issued by the Fed is backed on the asset side of the Fed's balance sheet. But I think that most people are currently in the dark about what the Fed intends for the future. There is some clarification in the current FOMC statement - we know that the Fed thinks inflation is too low - but we have no information about, for example, what the Fed intends to do with the large stock of MBS it holds. Does it intend to let this run off due to prepayments, defaults, and natural maturing of the debt, or does it plan to sell these assets and, if so, at what rate? I think a clearer statement of intentions (even if contingent) would be helpful.

Perhaps you could clear up my confusion on the "outside money" concept. Banks hold $1tr+ in Excess Reserves (ER's). Presumably this represents stored "potential energy" of lending, one that might be released at a future point in time, thus raising velocity and creating inflation.

My confusion resets with the significance of ER's in the current Fed Funds targeting regime. Imagine that ER's were zero today, and that a year from now banks experienced a step-function $1tr increase in credit demand. Assuming the Fed Funds rate was still zero, banks could satisfy that demand by borrowing, from the Fed, as much in reserves as they want at zero percent. That is, in FFR targeting system, the Fed supplies reserves as needed by the system to maintain the target rate.

So, my confusion is, what is the difference between, at zero percent FF rate, the banking system holding $1tr in loanable reserves now, and borrowing from the Fed $1tr of reserves a year from now? Why is one more potentially inflationary than the other?

(BTW, for purposes of the above, I am assuming the FFR and IOR are equal)

"Presumably this represents stored "potential energy" of lending, one that might be released at a future point in time, thus raising velocity and creating inflation."

Yes, though I tend to think of this simply in terms of outside money (M) being the sum of currency (C) and reserves (R). The private sector has to be willing to hold the total, C+R, and they have to be happy with the composition (C vs. R). If other assets than R become more attractive for banks, then something has to give. Either the interest rate on reserves has to go up to induce banks to hold the reserves they currently have, or else the private sector is going to hold their outside money in a different form - more currency and less reserves. This entails having the price level go up.

"Assuming the Fed Funds rate was still zero, banks could satisfy that demand by borrowing, from the Fed, as much in reserves as they want at zero percent."

You have banks holding zero excess reserves, and suppose that the Fed is targeting the fed funds rate at zero. Now, the demand for loans goes up - think of this as a technological improvement that increases loan demand. Presumably if the Fed did nothing the fed funds rate would rise, so if the Fed is targeting the fed funds rate at zero, it has to conduct open market purchases of assets to supply more reserves. Thus, your logic seems correct here.

"So, my confusion is, what is the difference between, at zero percent FF rate, the banking system holding $1tr in loanable reserves now, and borrowing from the Fed $1tr of reserves a year from now? Why is one more potentially inflationary than the other?"

Yes, it's hard it to see what the difference is, isn't it? Another way to look at this is that the Fed could sell all of its stock of MBS today (roughly equal to total excess reserves) and it may not matter (beyond allocational issues in the credit market - housing would do worse relative to other sectors maybe). Do you think this is inconsistent with anything I discussed in this post?

Thanks for your reply. I suppose it might be inconsistent with the concept that "outside money" is inherently potentially inflationary. In other words, at any given Fed Funds rate, the presence or absence of Excess Reserves is irrelevant: the system will have as much reserves as needed to meet loan demand.

Maybe its a fine point, but QE should be measured compared to something. Compared to the system's ability to borrow $ trillions whenever it wants at a given Fed Funds rate, the prospect of further trillions in QE is no different. Okay, it may be different in that it signals future actions that are of consequence, such as promising to monetize long term fiscal deficits or buy foreign currency/bonds. Both of these two measures are arguably guaranteed to produce inflation, unlike QE.

To a non-economist, it seems there is a lot of confusion, even amongst your peers, as to whether QE can produce inflation, how much, and by what mechanism.

I was wrong at least in one sense above: in the presence of fiscal deficits, QE will effectively monetize them in whole or in part, and therefore it is inherently more inflationary than the banking system's ability to borrow unlimited funds from the Fed at a given FF rate. To the extent a promise of more QE coincides with the prospect of large future fiscal deficits, this might be very inflationary. Perhaps this characterizes the current juncture.

"To a non-economist, it seems there is a lot of confusion, even amongst your peers, as to whether QE can produce inflation, how much, and by what mechanism."

Yes. The Old Monetarists think that outside money produces inflation no matter what, so they are puzzled by the fact that there is such a large quantity of excess reserves in the system, and it's not producing inflation. Old and New Keynesians think that inflation is a Phillips curve phenomenon. Given the large amount of resource slack they see, they think that inflation should be even lower than it is. People who are not wedded to Old Monetarism or Keynesianism are puzzling over a situation that is unprecedented.

Private banks are financial intermediaries. The Fed is a financial intermediary. Some of the Fed's liabilities (currency) compete with private bank liabilities. The Fed and private banks can hold some of the same assets (Treasury securities and MBS for example). Private banks borrow from the Fed, and use their reserve accounts to make transactions. Thus, the Fed and private banks are interrelated, and Fed actions will affect the choices made by private banks. However, the idea that you can summarize what the Fed is doing in some monetary aggregate, M1 for example, is misleading, and is part of where the Old Monetarists, e.g. Milton Friedman, went astray. The money multiplier stories you find in most money and banking textbooks are also misleading, for reasons that recent experience makes clear.